Greening institutional investment in India
India’s energy demand is increasing, and, to achieve its clean energy target of 175 GW by 2022, finance will be crucial.
One promising opportunity lies with foreign and domestic institutional investors who have $70 trillion and $564 billion assets under management, respectively. These investors are bound by their fiduciary duties meant to maximize financial returns to their beneficiaries, without taking excessive risks, while also meeting their liabilities over the long-run. Renewable energy, though a relatively new technology, is well matched to these needs as it offers high returns as well as meets environmental, social and governance (ESG) considerations in their investment strategies.
However, how can India unlock this opportunity to create a clean energy future?
A recent study by Climate Policy Initiative attempts to answer this question by developing a business case for institutional investors to invest in the Indian renewable energy sector, identifying key barriers to investment, and proposing potential pathways forward.
The changing economics of energy in India
According to the report, the renewable sector is becoming increasingly attractive compared with other energy investment opportunities in India. For instance, the solar tariff has actually become 23% cheaper than coal plants, and coal plants exhibit greater risk in cash flows (i.e. 40%) as compared to wind (i.e., 20%) and solar (i.e.,10%).
In the medium term, these changing economics mean that the existing power portfolio of investors, who are mostly exposed to fossil based investments instead of renewable investments, would underperform due to declining demand for fossil based power. Consequently, it is in the interest of institutional investors to gradually rebalance their portfolio in favour of climate friendly investments, in India and elsewhere.
Is India an attractive renewable energy market for institutional investment?
The study builds a case that India as a market is strong and economically attractive for foreign institutional investors compared to other similar markets across the world.
First, it benefits from strong renewable policy commitments as well as a large market size — ~480 GW expected capacity addition over 2016-40 — that is third only to China and the United States. Second, India is ranked 2nd in Ernst & Young’s renewable energy country attractiveness index, based on five pillars including macroeconomic environment, policy enablement, supply–demand dynamics, project delivery, and technology potential. Third, renewable energy in India provides a financially attractive investment, as measured via excess returns, the difference between the expected return on capital invested and the weighted average cost of capital. India offers higher excess returns of 3.5% compared with other large markets, such as the US (2.4%) and China (1%). While some markets provide higher excess returns than India—for example, Mexico, Canada, and Chile – these are much smaller markets.
So what’s next?
Institutional investors with long-term investment horizons are mostly seeking yield generating investments in low risk and long duration assets, i.e., traits that align well with the current investment profile of renewable energy; this has changed from small size and high risk-high return investments to large size and medium risk-moderate return investments. Although the expected return from renewable energy projects have come down from 20% to 15% over time, this still matches institutional investors’ overall India market portfolio return requirements.
Renewable energy sector stages with risk-return mapping
However, our study finds there are still some barriers to unlocking this apparent match – including, sector specific risks like off-taker risk and limited listed and highly graded investment opportunities, along with currency risk.
The good news is that with appropriate regulatory and policy changes, the sector can provide a high match with institutional investors’ investment objectives.
For example, the central and state agencies could address the off-take risk through a transparent and credible payment security mechanism. Regulators could consider developing incentives to encourage banks and Non-Banking Financial Companies (NBFCs) to securitize their renewable energy loan portfolios, freeing up capital for more renewable energy projects. And investors themselves can consider developing risk management frameworks to assess and manage climate risk, identifying and investing in forward looking investment opportunities, renewable energy being one, to mitigate climate risk in their portfolio.
These steps, and the others we outline in the study, are a win win for all – for India, it’s a way to get much needed capital in a much needed area. For investors, their long-term portfolios depend on it.